Chapter 1 - The Company and It's Environment Flashcards
Describe the advantages and disadvantages of alternative forms of business organization.
o Sole proprietorship
Advantages: ease of formation, few regulations, no corporate income taxes.
Disadvantages: unlimited liability, limited life, difficult to raise capital to support growth
o Partnership
Similar advantages and disadvantages to sole proprietorship
o Corporation – legal entity separate from its owners and managers
File papers of incorporation with the state
Advantages: unlimited life, easy transfer of ownership, limited liability, ease of raising capital
Disadvantages: double taxation, cost of set-up and report filing
State the primary goal of a manager in a publicly traded firm, and explain where social responsibility and business ethics fit in.
- Shareholder wealth maximization maximizing the fundamental stock price.
- Firms should behave ethically and have responsibilities to society at large.
- Employment goes up in firms that make managers into owners
- Consumer welfare is higher in capitalist free market economies.
- Firms are admired because they have high stock returns, high quality from customer’s view and employees like working there.
Be able to describe the Sarbanes-Oxley Act of 2002 and some of its provisions.
- Passed in response to widespread corporate frauds and failures. Changed management’s responsibility for financial reporting significantly.
- Implemented new rules for corporations like setting new auditor standards to reduce conflicts of interest and transferring responsibility for the complete and accurate handling of financial reports
- Harsher penalties for violators
- Enhanced disclosure requirements to increase transparency.
Came about in part due to the Enron financial scandal in 2002. Protects whistleblowers against legal repercussions for reporting financial wrongdoings within a company that may be illegal, allowed said whistleblower to be reinstated if wrongly terminated, and made it a criminal act for a CEO or CFO to knowingly falsely certify a company’s financial position
Be able to describe the capital allocation process.
- How the CEO distributes and invests a company’s financial resources in ways to increase its efficiency and maximize profits.
- Options:
o Returning cash to shareholders via dividends, repurchasing shares of stock, issuing a special dividend, or increasing R&D budget.
o Can also opt to invest in growth initiatives like acquisitions and growth expenditures - 3 important features:
o First, new financial securities are created
o Second, different types of financial institutions often act as intermediaries
o Third, activities occur in a variety of financial markets
Understand securitization and be able to discuss and explain at least 3 examples.
- Were limited in the amount of mortgages they could fund by the amount of deposits they could raise
- Were raising money through short term floating rate deposits, but making loans in the form of long term fixed rate mortgages
- When interest rates increased, S&Ls faced crisis because they had to pay more to depositors than they collected from mortgagees
- Many went bankrupt when IR rose in the 80s
- After 80’s, S&L’s put their mortgages into pools and sold the pools to other organizations like Fannie Mae
- After selling a pool, the S&L’s have funds to make new home loans and risk is shifted to fannie mae
- Fannie mae doesn’t keep the mortgages - puts it in pools and sells shares of these pools to investors. Risk is then shifted to investors but they get a rate of return close to the mortgage rate which is higher than the rate S&Ls pay their depositor. More risk but more return.
- THIS IS CALLED SECURITIZATION SINCE NEW SECURITIES HAVE BEEN MADE BASED ON ORIGINAL SECURITIES (mortgages in this example) car/student loans and credit card balances can also be securitized
Explain the factors that influence the required rate of return in the economy.
- Interest rates, risk, market returns and the overall economy.
- Must consider cost of capital and inflation
- RRR is the minimum return an investor will accept for owning a company’s stock.
- Used to analyze the profitability of potential investment projects.
Be able to list and explain the basic types of financial institutions.
- investment banks: help companies raise capital by advising on the pricing of new securities, buying them and then reselling to investors.
- Commercial banks: raise funds from depositors and by issuing stock/bonds to investors
- savings & loans- accept deposits from many small savers and lend the money to home buyers and consumers
- mutual savings banks, and credit unions, life insurance companies, mutual funds (exchanged traded funds EFTS), pension funds, hedge funds and private equity funds
Be able to list and explain the basic types of financial markets.
- Method of exchanging one asset (usually cash) for another asset
- Physical assets vs. financial assets: physical are tangible like autos, real estate, wheat. Financial are stocks, bonds, mortgages, etc.
- Spot vs. future markets: spot is where assets are being bought/sold for on the spot delivery. Future is when the delivery is in the future.
- Money vs. capital markets: money is for short term, highly liquid debt securities. Capital is for stocks and debt maturing more than a year in the future.
- Primary vs. secondary
Explain the difference between primary and secondary market transactions, and the importance of secondary markets.
- Primary: markets where the corporations raise new capital. Issuer receives proceeds from the sale.
o Ex: if a private company has an IPO or if a public company sells a new issue of common stock. - Secondary: markets where existing, outstanding securities are traded among investors.
o Issuing firm doesn’t receive proceeds and is not directly involved.
o Provide liquidity for investors who need cash or want to reallocate their investments to better opportunities.
o Foster entrepreneurship
o Measure of value by buyers and sellers
Understand the US stock market system, its participants and procedures for transactions.
Be able to explain what happened during the 2007 crisis and why it happened.
- Started years earlier with cheap credit and lax lending standards that fueled a housing bubble
- When the bubble burst, financial institutions were left holding trillions of dollars worth of near-worthless investments in subprime mortgages
- Millions of homeowners owed more on their mortgages than their homes were worth
- Great recession cost many people their jobs, savings, or their homes.
Be familiar with procedures put in place to help curtail future financial crises.
- Dodd Frank Wall Street Reform and Consumer Protection Act – making sure borrowers fully understand the terms and risks of the mortgage contracts, mortgage originators verify borrower’s ability to repay
o Volcker rule – prevents banks from making highly leveraged bets on risky assets
o Also provides more oversight of hedge funds and credit rating agencies to try to spot potential landmines before they explode. Reduces financial system’s exposure to risk caused by derivative trading
Financial securities
claim on a FCF that’s standardized and regulated.
Ex: debt, equity, derivatives
open outcry auction
method of matching buyers and sellers where they’re face to face literally an auction
what is a firm’s fundamental value (intrinsic value)
prevent value of its FCF when its discounted at the WACC. if the market price shows all relevant information, the observed price is also the intrinsic price.
